Is this a Bubble?

2/23/12 - 05:32 AM

There are many definitions for what comprises a "Bubble."  An "extraordinary event" is perhaps a good generalized answer.  But, then, this begs to know what is ordinary, what comprises an event, and what timeframe bounds that event?  Some would say "extraordinary" is what is abnormal.  This begs to define normal.  Defining normal is no easy task.  The rate of inflation can be defined over any period of time.  But, what timeframe  is normal for you?  Normal could be 30 years, or 30 days depending on your perspective and objective.  Mortgage bankers and borrowers have timeframe tuned to the 30 year longer term.  Our federal government publishes a monthly CPI for those with short-term perspectives and objectives.  The event defined by this article will be solely the buying and selling of residential single family Real Estate. The objective is to make a profit.        A real estate Bubble has a profound affect on a major segment of our population.. For this article to remain small and  meaningful we shall only address the affect of a bubble on those who own real estate as either a homeowner or as an investor.    We shall not address people affected by a real estate Bubble such are builders, suppliers, carpenters, plumbers, and other such tradesmen.        Below we shall offer only thoughts on what is Normal, and then discuss the effects of a Bubble on the Homeowner and the Investor. Then, leading toward our conclusion, we'll discuss the role of leverage as it afffects everyone.  Normal       We suggest normal be based on historical statistical data, but first consider the following.  If one only buys or sells a property every 15 years, then that is normal for him.  In his home city, if about 6 to 7% of the residents do the same, then at the end of 15 years (on average) every house will have changed hands one time.  In that 15 years, if everyone's house doubled in price, everyone averaged nearly 5% a year compounded appreciation.  If there were 150,000 homes in that city, then 10,000 changed hands every year (on average).  In reality, this snippet of data is the typical (normal) average across the  United States.  We suggest these statistics provide a baseline definition for normal.     During that 15 years what would it have mattered if there were 4 years of 2% appreciation followed by 2 years of 15% appreciation? What if a couple months showed 30% appreciation?  It makes VERY little difference in the final price when averaging appreciation over 15 years.  If two months out of 180 averaged 30% appreciation, it is not rocket science to suggest that for those  two months the appreciation was abnormal. The Homeowner     You need a place to live.  If you sell your home, presumably you will buy another.  Typically, your new home will have about the same value and features. You replaced A with B, and if there was a Bubble, it was more or less  irrelevant.  If you neither bought nor sold, but increased your debt with home equity loans, please read the "Leverage" paragraph below. The Investor (short-term)     From a short-term perspective:  If you sold a property for more than you paid, and you cannot replace it at a lower cost. Did you really make a profit?  Unless you change from Real Estate to another asset class wherein you made more money than having stayed with Real Estate, you either lost money or broke even.  The very astute investor, who made a profit, accurately "timed the market" in two different asset classes.  Are you this type of investor?  If not, the Bubble is irrelevant.      If you traded only in the Real Estate asset class, and you made a profit,  you probably did so with a great deal of analysis and/or sweat labor as both a wage earner and an investor. Otherwise, perhaps you were very lucky.  Of this hard working person, it probably did not matter if there was, or wasn't, a Bubble.  The Investor (long-term)     This person is defined by a "buy and hold" strategy. Expenses are partially offset by both rental income and income tax deductions.  Profit is obtained when appreciation exceeds general inflation.  This is compounded when debt is successfully leveraged.   Sweat equity, exceptional professional or personal management, and market savvy can further compound eventual profits.  To this person, who does not sell, the Bubble is either a plus if it prices are up and above inflation, or is hardly relevant if income to expenses ratios remain the same. Leverage     Using "Other Peoples Money"  is a two edged sword. It magnifies risk taking and profit.  Levarage applies to all property owners mentioned above.  Living on the edge with massive amounts of borrowed money can be very profitable, or it can be a total disaster. It is usually very stressful. This person has read this web page in excruciating detail looking for answers.  He knows there are good Bubbles and bad Bubbles, and he is desperately searching for clues to what the future portends.  He is a gambler knowing from historical data that gambling in Real Estate has far better odds than gambling in Las Vegas. All he wants to do is avoid the bad Bubble.  If he has timed this market improperly, he may lose everything. If you are this person, this web page has no predictions. If you have timed the market well, a good Bubble magnifies profit.  Conclusion     Basically, it does not matter if we are in a Bubble.  What hurts in a good Bubble is that government taxes you more, insurance companies charge you more, and it costs you more to buy and sell.  These factors exacerbate the ending of good Bubbles, and they  effect the start of a bad Bubble. But, if history is a predictor of the future, then there will one day be another good Bubble.  Low Fed. interest rates and low real estate taxation are the lifeblood of a good Bubble. As they go, so goes a Bubble.  As always, keep tuned to government!